Direct Labour Cost Method: Calculation, Advantages and Disadvantages

Direct labour cost method is a simple and easy method and widely used in most of the concerns.

The overhead rate is calculated as under:

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Overhead Rate = Production Overhead Expenses/Direct Labour Cost × 100

Generally from past experience or on the basis of estimates, the percentage of factory expenses to direct wages is calculated and jobs are charged according to this percentage. Suppose in a year direct wages paid in a factory are estimated to be Rs 60,000 and the factory expenses Rs 30,000. Then the percentage of factory expenses to direct wages comes to 50. The factory expenses in the next year will be taken at 50% of the direct wages.

Direct labour cost method is suitable under the following circumstances:

(i) Where direct labour constitutes a major proportion of the total cost of production.

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(ii) Where production is uniform.

(iii) Where labour employed and types of work performed are uniform.

(iv) Where the ratio of skilled and unskilled labour is constant.

(v) Where there are no variations in the rates of pay i.e., the rates of pay and the methods are the same for the majority of the workers in the concern.

In some concerns a separate rate is calculated for the fringe benefits and applied on the basis of direct labour cost.

Advantages:

Following are the advantages of this method:

(i) Automatic consideration is given to the time factor as wages paid are normally proportional to the time worked.

(ii) Labour rates are more stable than material prices.

(iii) Certain variable overhead expenses vary to certain extent with the number of workers employed and hence the charge to production is related to the amount of wages paid which is proportional to the number of workers.

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(iv) Basic data required for calculation of this rate is easily available from the wages analysis statement and no extra labour cost is involved.

Disadvantages:

Following are the main disadvantages:

(i) No distinction is drawn between skilled and unskilled labour and differences in rates of pay. Jobs upon which highly paid workers are engaged will be burdened with greater charges than those upon which low paid workers are employed. This is unjust as it is the unskilled workers who are responsible for greater expenses in the form of wasted material, depreciation etc.

(ii) Time factor is completely ignored if workers are paid on piece rate basis.

(iii) No distinction is drawn between the production of hand workers and that of machine workers.

(iv) The method gives inaccurate result when workers are paid overtime premium as higher hourly rates are paid for overtime work. But overhead expenses will increase in the same proportion. In fact, many expenses remain constant.

(v) No distinction is made between fixed and variable expenses.

(vi) Where labour is not important factor of production, absorption of overhead expenses will not be equitable. It ignores the important factors like extensive use of plant and equipment.

(vii) It is not suitable in case of piece workers as the same rate will be applied for absorbing overhead expenses to all workers whether they are efficient and take less time or inefficient and take more time.